Learn mean-reversion trading

4.1.7 · Stock-Market › Trading vs Investing & Styles

Yeh kaam kyun karta hai? Markets herd behavior aur emotion ki wajah se overshoot karti hain. Ek bura earnings report panic selling karaata hai — price fair value se neeche chali jaati hai. Ek hot product launch euphoric buying karaata hai — price fair value se upar chali jaati hai. Mean (average price) gravity ki tarah kaam karta hai, price ko time ke saath wapas kheenchta hai.

Mean-Reversion Trading kya hai?

Key Components:

• Mean (Average): Typically moving average (MA) hoti hai — jaise 20-day MA, 50-day MA, ya Bollinger Band midline.
• Deviation Measurement: Price mean se kitni dur hai (standard deviations, RSI, Bollinger Bands).
• Entry Signal: Price lower threshold ke neeche cross kare → BUY. Price upper threshold ke upar cross kare → SELL/SHORT.
• Exit Signal: Price mean par wapas aa jaaye ya use cross kar le.

Mean kyun? Historically, zyaatar stocks ek trend ke around oscillate karti hain. Agar ek stock normally ₹100 par trade karti hai aur kisi fundamental change ke bina ₹80 par aa jaati hai, toh probability ₹100 ki taraf wapas return hone ka favor karti hai.

Mean-Reversion Logic ka Derivation

Step 1: Mean Define Karo

Mean ek lookback period par price ki expected value hai. Simplicity ke liye Simple Moving Average (SMA) use karo:

jahan $P_t$ time $t$ par price hai, aur $n$ lookback period hai (jaise 20 days).

SMA kyun? Yeh noise ko smooth out karta hai aur $n$ days par "fair value" consensus represent karta hai.

Step 2: Deviation Measure Karo

Current price $P_t$ mean se kitni dur hai?

Lekin absolute deviation asset price par depend karti hai (₹10 deviation ₹50 stock ke liye zyada matter karti hai, ₹500 stock ke liye nahin). Toh normalize karo:

jahan ${\sigma }_n$ $n$ days par price ki standard deviation hai:

Yeh $z$ z-score kehlata hai. Yeh batata hai ki price mean se kitne standard deviations dur hai.

Z-score kyun?

• $z=0$: Price mean par hai (koi trade nahin).
• $z=-2$: Price mean se 2 std devs NEECHE hai → oversold → BUY signal.
• $z=+2$: Price mean se 2 std devs UPAR hai → overbought → SELL signal.

Step 3: Entry aur Exit Rules

Entry: Jab $|z|>\text{threshold}$ (jaise 2), opposite position enter karo:

• $z<-2$: BUY (expect karo ki price mean par wapas rise karegi).
• $z>+2$: SELL/SHORT (expect karo ki price mean par wapas fall karegi).

Exit: Jab price mean par wapas aa jaaye ($z\approx 0$) ya use cross kar le.

Yeh thresholds kyun? Normal distribution mein, ~95% data 2 standard deviations ke andar hota hai. Jab $|z|>2$, price extreme 5% mein hai, statistically revert hone ki zyada probability hai.

Mean-Reversion ke Indicators

1. Bollinger Bands

jahan $k=2$ typically hota hai (wider bands ke liye 2.5 ya 3 bhi adjust kar sakte ho).

USE kaise karein:

• Price Lower Band touch kare → oversold → BUY.
• Price Upper Band touch kare → overbought → SELL.
• Price Middle Band par wapas aaye → EXIT.

Kaam kyun karta hai? Bollinger Bands z-score concept ko visualize karte hain. Bands volatility ke dauran expand hote hain (bada $\sigma$) aur consolidation ke dauran contract hote hain.

2. Relative Strength Index (RSI)

Typical $n=14$ days.

Interpretation:

• RSI < 30 → oversold → BUY.
• RSI > 70 → overbought → SELL.
• RSI = 50 → neutral (koi mean-reversion signal nahin).

Kyun? RSI upward vs downward momentum compare karta hai. Extreme RSI matlab one-sided pressure jo khud exhaust ho jaata hai, reversal trigger karta hai.

3. Z-Score (Direct Calculation)

Jaise upar derive kiya. RSI/Bollinger Bands se zyada flexible hai kyunki tum lookback period aur threshold khud control karte ho.

Worked Example 1: Bollinger Band Trade

Setup: Stock ABC ₹100 par trade kar raha hai. 20-day SMA = ₹100, 20-day $\sigma$ = ₹5. Bollinger Bands $k=2$ ke saath:

• Upper Band = 100 + 2(5) = ₹110.
• Lower Band = 100 - 2(5) = ₹90.

Day 1: Price ₹88 par drop karti hai (Lower Band ke neeche).

• Yeh step kyun? ₹88 par price mean se 2.4 std devs neeche hai (z = (88-100)/5 = -2.4). Yeh extreme hai. Historical data dikhata hai ki price yahan se 90%+ time mean par wapas return karti hai.
• Action: ₹88 par 100 shares BUY karo. Risk: ₹2 per share (stop-loss ₹86 par agar breakdown continue ho).

Day 5: Price ₹98 tak rise karti hai (Middle Band ke paas).

• Exit kyun? Mean-reversion mean par return assume karta hai, continuation nahin. ₹98 par rubber band snap back ho chuka hai. Bina naye catalyst ke aage rise ki probability kam hai.
• Action: ₹98 par 100 shares SELL karo. Profit = (98-88) × 100 = ₹1,000.

₹110 ka wait kyun nahin? Mean-reversion momentum nahin hai. Target mean hai (₹100), opposite extreme nahin. Zyada der rukne se reversal risk aata hai.

Worked Example 2: RSI Mean-Reversion

Setup: Stock XYZ ₹200 par. RSI(14) = 25 (oversold).

Logic:

• RSI = 25 matlab recent losses gains se bahut zyada hain. Sellers exhausted ho gaye.
• Yeh step kyun? Jab RSI < 30 hota hai, historically 70% time price ranging markets mein 5-10 days ke andar rebound karti hai.
• Action: ₹200 par BUY karo. Target ₹210 set karo (jahan RSI wapas 50 par aaye, neutral zone).

3 Days Baad: RSI 52 tak climb karta hai, price ₹208 par.

• Exit kyun? RSI wapas neutral = mean-reversion complete. Longer hold karne ka koi edge nahin.
• Action: ₹208 par SELL karo. Profit = ₹8 per share.

Risk Management: Agar RSI aur giray (jaise 15 tak), toh yeh breakdown signal hai, mean-reversion nahin. Stop-loss ₹195 par (agar price oversold RSI ke bawajood naya low banaye).

Mean-Reversion FAIL kab hota hai

Yeh sahi kyun lagta hai: Ranging market mein, oversold = opportunity. Toh tumne khud ko train kiya: "Oversold = buy."

Fix: Mean-reversion range-bound markets mein kaam karta hai (sideways price action). Trending markets mein (strong uptrend ya downtrend), "oversold" mahino tak oversold reh sakta hai. Example: Ek stock ₹500 se ₹400 gir jaati hai (RSI = 25). Tum khareedte ho. Yeh ₹300 par aa jaati hai (RSI abhi bhi 25). Tum aur khareedte ho. Yeh ₹200 par aa jaati hai. Tum wipe out ho jaate ho.

Kaise bachein:

1. Pehle trend check karo. 200-day MA use karo: Agar price 200-day MA ke neeche hai aur gir rahi hai, toh trend DOWN hai. Mean-reversion longs se trend se mat lado.
2. ADX (Average Directional Index) use karo. ADX > 25 = trending market. Mean-reversion skip karo. ADX < 20 = ranging market, mean-reversion ke liye safe.
3. Hard stop-losses set karo. Agar tumne oversold signal par kharida, aur price naya extreme LOW banaye, toh exit karo. Double down mat karo.

Mean-Reversion Trading kab Use Karein

Best Conditions:

• Range-bound markets: Price support aur resistance ke beech oscillate kare bina strong trend ke.
• High volatility: Bade swings frequent overbought/oversold extremes create karte hain.
• Liquid stocks/indices: Tight spreads, low slippage. Examples: Nifty 50 stocks, large-cap US stocks.

Avoid Kab Karein:

• Strong trends (up ya down): Trend traders paise kamaate hain; mean-reversion traders lete hain.
• Low volatility: Chhote swings → infrequent signals → opportunity cost.
• News-driven moves: Fundamental change (merger, bankruptcy) → naya mean; purana mean irrelevant.

Mean-Reversion vs. Momentum Trading

Key Insight: Yeh opposite strategies hain. Market regime ke hisaab se sahi wala use karo. Bull market mein (momentum regime), mean-revert mat karo; trend ride karo. Choppy market mein (range regime), momentum chase mat karo; bounces trade karo.

Example Trade Setup Checklist

1. Mean identify karo: 20-day SMA ya Bollinger Bands plot karo.
2. Extremes measure karo: Z-score calculate karo ya RSI check karo.
3. Range-bound market confirm karo: Price stable support/resistance ke beech ho, koi strong trend nahin, ADX < 20.
4. Entry: Price extreme par ho (z < -2, RSI < 30, ya lower Bollinger Band par).
5. Position size: Capital ka 1-2% risk karo (stop-loss distance se calculate karo).
6. Stop-loss: Recent low ke neeche (longs ke liye) ya recent high ke upar (shorts ke liye). Agar price naye extreme par break kare, exit karo.
7. Target: Mean (SMA, middle Bollinger Band, ya RSI = 50).
8. Exit: Target par ya agar market regime change ho (trend emerge ho).

Stock prices yo-yo ki tarah hain. Kabhi kabhi log panic mein stock bahut saste mein bech dete hain (yo-yo bahut neeche chala jaata hai). Kabhi kabhi log excited ho jaate hain aur use bahut mehnge mein khareed lete hain (yo-yo bahut upar ud jaata hai). Lekin "string" average price hai, aur stock usually us average par wapas aa jaata hai.

Mean-reversion traders woh bacche hain jo yo-yo ko bottom par pakad lete hain aur jab woh middle par wapas aata hai toh bech dete hain. Woh top tak wait nahin karte — woh risky hai! Unhe bas easy bounce back to normal chahiye hoti hai.

Trick? Pakka karo ki yo-yo string se attached hai! Agar company actually bankrupt ho rahi hai, toh koi string nahin hai — yo-yo bas girta hi rehta hai aur kabhi wapas nahin aata. Toh check karo: kya yeh normal bounce hai, ya kuch actually toot gaya hai?

"Trend Se Mat Lado, Range Trade Karo"

• Agar ADX > 25, trend boss hai. Koi mean-reversion nahin.
• Agar ADX < 20, range king hai. Mean-revert karo!

Connections

Related Notes:

• 4.1.01-Trading-vs-investing-core-difference — Mean-reversion ek trading strategy hai (short-term), investing nahin.
• 4.1.05-Learn-momentum-trading — Mean-reversion ka opposite; jaano kab strategies switch karni hain.
• 4.1.08-Learn-technical-indicators — RSI, Bollinger Bands, ADX sab mean-reversion mein use hote hain.
• 4.2.01-Risk-management-position-sizing — Mean-reversion ke liye crucial: tight stops kyunki tum current move ke against bet kar rahe ho.
• 3.2.04-Support-and-resistance-levels — Mean-reversion tab best kaam karta hai jab price range mein support/resistance se bounce kare.

Broader Context:

• Mean-reversion ek statistical edge hai, certainty nahin. Markets ranges mein 60-70% time mean-reverting hote hain, 100% nahin.
• Options strategies ke saath well combine karta hai (jaise oversold hone par puts sell karo, premium collect karo jab woh revert ho).

#flashcards/stock-market

Mean-reversion trading ka core assumption kya hai? :: Asset prices ek long-term average (mean) ke around fluctuate karti hain, aur extreme deviations temporary hoti hain. Prices time ke saath mean par wapas return karti hain.

Mean-reversion trading ke liye best indicators kaun se hain? :: Bollinger Bands, RSI, z-score (direct calculation), aur ADX (ranging market confirm karne ke liye). Yeh sab mean se deviation measure karte hain aur extremes identify karte hain.

Concept Map